Tax Reform Changes to Net Operating Loss (NOL) Rules
The Tax Cuts and Jobs Act (TCJA) made major changes to the NOL rules. These changes will significantly alter income tax accounting for deferred tax assets (DTA) stemming from NOL carryforwards. The TCJA made the following changes to the NOL rules:
- NOLs of life insurance companies and general Subchapter C corporations generated in years ending after December 31, 2017, can’t be carried back to offset prior year’s income but can be carried forward indefinitely.
- NOLs of life and general C corporations generated in years beginning after December 31, 2017, can only offset 80 percent of taxable income in any given year.
- NOLs of property and casualty insurers were not affected by the TCJA; property/casualty NOLs can be carried back two years and forward 20 years with no taxable income limitation.
- The repeal of the alternative minimum tax (AMT) means AMT NOLs are a thing of the past.
- NOLs generated in tax year ending before January 1, 2018, remain subject to the pre-TCJA carryback/carryforward rules. Furthermore, NOLs generated in tax years beginning before January 1, 2018, can offset 100 percent of regular taxable income in any tax year.
- Capital loss carryback rules are unchanged; net capital losses are still carried back three years and carried forward up to five years to offset net capital gains.
Tax Planning Strategies
For generally accepted accounting principles (GAAP) purposes, DTAs are recognized on the balance sheet to the extent they meet the “more likely than not” (MLTN) realization standard. A company with cumulative losses in recent years may find it difficult to satisfy this MLTN test. Companies in this situation will look to tax planning strategies to generate the requisite income to “realize” their DTAs.
The analysis for pre-TCJA years went something like this: A reporting entity had DTAs, some of which emanated from NOLs. Other DTAs may have related to asset or liability bases differences (temporary differences) that would reverse and either be offset by future income or result in future NOLs (latent NOLs). If future income couldn’t be predicted, and existing and latent NOLs were in danger of expiring unused, a tax planning strategy may have provided the requisite income to ensure a tax benefit would be achieved. For property/casualty insurers, this analysis still applies as their NOL rules remain static after tax reform. For life insurers, however, the landscape has changed.
A tax planning strategy is defined in Accounting Standards Codification (ASC) Topic 740 as “an action that management ordinarily might not take, but would take, if necessary, to realize a tax benefit for a carryforward before it expires” (ASC 740-10-55-39). Although the changes to the NOL rules for life insurers provide an infinite carryforward period, some commentators have questioned whether this sounds a death knell for tax planning strategies; since NOLs don’t expire, a tax planning strategy to ensure an NOL won’t expire can’t by definition exist (or so goes the line of thinking).
However, this seems to be a draconian view of an otherwise liberating change in the NOL rules and, arguably, counterintuitive in that the change in the carryforward rules from a fixed to an indefinite period would limit DTA recognition. Given that nearly all of the GAAP guidance was drafted when attributes like NOLs could expire unused, it seems the definition of a “tax planning strategy” needs to be revisited and could include a “significant acceleration of the timing of NOL utilization” as an addition to the expiring NOL as fact patterns justifying tax planning strategy consideration.
However, some existing authority provides a basis for an expanded view of a “tax planning strategy.” ASC 740-10-55-43 appears to tacitly acknowledge that a tax planning strategy to accelerate the reversal of deductible temporary differences to offset future income in early years, to the extent prudent and feasible, can be used, though NOL expiration may or may not be at risk.
ASC 740 also denotes, "In other circumstances, a tax planning strategy to accelerate the future reversal of deductible temporary differences in time to offset taxable income that is expected in an early future year might be the only means to realize a tax benefit for those deductible temporary differences if they otherwise would reverse and provide no tax benefit in some later future year(s)."
The practice of most leading accounting firms follows a similar line of reasoning. Companies with NOLs that find it difficult to project long-term financial results may be expected to show that near-term results support DTA recognition. This often will entail the use of tax planning strategies, though NOL expiration isn’t imminent.
For Statutory Accounting Principles (SAP) purposes, much of the GAAP guidance carries over and is cited in the SSAP 101 Q&A. However, paragraph 11.b. of the admissibility test provides a short window of time for companies to establish that DTAs are “more likely than not” realizable. The use of tax planning strategies in the three-year reversal period essentially involves a fictionalized NOL expiration. Q&A 13.7 states that “[t]he potential reversal beyond the appropriate period is comparable to an expiring net operating loss, in that the deduction would not provide a tax benefit under SSAP No. 101.” Q&As 13.8–13.10 provide an example of a tax planning strategy that involves the funding of a welfare benefit fund to accelerate the deductibility of post-retirement health plan expenses. Without the accelerated deduction, tax benefits would “expire” by falling outside of the three-year window provided in paragraph 11.b.
This doesn’t necessarily mean SAP filers are out of the woods and their use of tax planning strategies beyond reproach. Since the GAAP standard serves as the basis for its SAP counterpart, it’s difficult to imagine one could achieve a better answer under the latter versus the former. Hopefully, additional GAAP guidance will be forthcoming that clarifies this issue for life insurers.
Admissibility Test & NOLs
Life insurers need to be cognizant of the effect the NOL changes will have to the admissibility test. Each of the three parts of the test have been impacted by tax reform.
This first part of the admissibility test looks to “[f]ederal income taxes that can be recovered through loss carrybacks.” Since life company NOLs generated after 2017 can’t be carried back, this paragraph won’t provide a means to admit ordinary DTAs of life insurers. Capital losses generated in 2018 and subsequent years can still be carried back three years; thus, paragraph 11.a. can provide a basis for capital DTA admissibility.
The combination of an inability to carryback life NOLs and the 80 percent taxable income limitation make paragraph 11.b. more difficult to apply after tax reform. The following two examples highlight some of the complexity.
Assume ABC Life Insurance Company has a $3,000 ordinary temporary difference related to deferred compensation. ABC determines $1,000 of the temporary difference will reverse each year for three years. The federal income tax rate is 21 percent. If ABC estimates $3,000 of taxable income in year one for purposes of the “with/without” test of paragraph 11.b., the $1,000 of year one reversals will reduce tax by $210. However, further assume ABC can’t accurately predict income in years two and three. The remaining $2,000 of taxable income in year one can’t be offset by the $1,000 reversals in years two and three, which essentially will become NOLs. Consequently, ABC can only admit a DTA of $210, even though the income and deductions during the three-year reversal period offset in total. If ABC was taxed as a property/casualty insurer, the reversals in years two and three could be carried back, thereby supporting admissibility of the entire DTA of $630.
Assume the same facts as in Example One except the only projected income is $3,000 in year three. The $1,000 reversals in years one and two will result in NOLs to be carried forward to year three. The $1,000 reversing in year three would reduce taxable income to $2,000. However, the 80 percent limitation would apply to the NOL carryover, meaning only $1,600 could be used in year three. The remaining $400 (a DTA of $84) would be nonadmitted under paragraph 11.b.
The effect of tax reform on this portion of the admissibility test isn’t limited to life insurers. Property/casualty insurers also are affected, albeit to a lesser extent. Paragraph 11.c. provides for admissibility of long-term DTAs (reversing after three years) and remaining short-term DTAs to the extent of DTLs. However, if the DTLs are projected to reverse and create income in year four, for example, DTAs expected to reverse in year eight couldn’t be carried back to offset the year four income. This holds true for post-TCJA years for property/casualty companies because the NOL carryback is limited to two years; however, life companies are affected more because there is no NOL carryback.
Q&A 2.7 identified this problem but merely indicates a filer “may be required to consider the reversal patterns of its taxable temporary differences.” Whereas the two-year NOL carryback may provide some margin for error for property/casualty companies, no such margin exists for life companies. If scheduling is required for a life insurer, and DTAs are clearly going to reverse after DTLs, the DTAs wouldn’t be admissible under paragraph 11.c. The question is, when is scheduling required? Facts and circumstances, such as the magnitude of the temporary differences, should be considered in this determination. The ability to “reasonably conclude” that admissibility is appropriate can be arrived at without scheduling.
There are tax reform provisions such as the new NOL rules for life insurers that have created GAAP and SAP tax accounting issues. BKD will continue to monitor developments and alert the industry if related guidance is issued. In the meantime, contact Tom or your trusted BKD advisor if you have questions.